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Capital budgeting

May 8, 2008

CBO released a new report this morning, prepared at the request of the Chairman of the House Committee on the Budget, analyzing the advantages and disadvantages of adopting a capital budget at the federal level. In addition, I am testifying on infrastructure spending this morning before a joint hearing of the House Committee on the Budget and the Committee on Transportation and Infrastructure. That testimony covers a broader array of topics related to infrastructure spending; a short summary is available here.

The capital budgeting report makes the following key points:

The federal budget, which presents the governments expenditures and revenues for each fiscal year, serves many purposes. It enables policymakers to allocate resources to serve national objectives, provides the basis for agencies management of federal programs, gives the Treasury needed information for its management of cash and the public debt, and provides businesses and individuals with information to make an informed assessment about the governments stewardship of the publics money and resources. Inflows and outflows are recorded mostly on a cash basis because those transactions are readily verifiable and they provide policymakers and the public with a close approximation of the governments annual cash deficit or surplus.

Some observers have proposed modifying the budgeting system by implementing a capital budget for the federal government, which would distinguish certain types of investments from other expenditures in the budget. One commonly discussed approach would segregate cash spending on capital projects in a capital budget and report in the regular budget the depreciation on federal capital assets, thus allocating current costs to future time periods. Such an approachwhich would move from the current, primarily cash-based budgeting system to one that relies more on accrual-based accountingwould be similar to private-sector accounting in that it would spread capital costs over the period when benefits are accruing from the investment.

Proponents of capital budgeting assert that the current budgetary treatment of capital investment creates a bias against capital spending and that additional spending would benefit the economy by boosting productivity. They note that capital budgeting could better match budgetary costs with benefit flows and eliminate some of the spikes in programs budgets from new investments. The existence and extent of any such bias, however, depends on how differently policymakers would behave with a capital budget instead of the existing budgetary treatment of capital investments. Furthermore, although evidence suggests that additional capital spending could have larger economic benefits than costs, the economic benefits of increasing capital spending by the federal government would partly depend on how well the additional funds were targeted to high-value projects and on the extent to which they would displace spending that would otherwise be undertaken by the private sector or other levels of government.

Moving to a budget that is more reliant on accrual-based accounting could increase complexity, diminish transparency, and make the federal budget process more sensitive to small changes in assumed parameters, such as depreciation rates. (Indeed, other nations have considered adopting capital budgets, but generally decided against it for those same reasons.) Adopting an accrual approach to only one aspect of the budget could raise concerns as to whether the budgeting system would provide a fair basis for allocating the government's resources among competing priorities. In addition, providing special treatment to certain areas of the budget, such as capital spending, could make the process more prone to manipulation. For example, arriving at a definition of capital for budgeting purposes could be a significant challenge. Concerns about such issues largely explain why previous groups charged with exploring budgetary concept issuesincluding the 1967 Presidents Commission on Budget Concepts and the 1999 Presidents Commission to Study Capital Budgetinghave rejected the idea of a separate capital budget for the federal government.

More limited changes to the current process might still accomplish the goal of focusing on capital investment but be simpler to implement than a capital budget as traditionally defined. One approach would be to create a category for capital spending as part of a restoration of the statutory budget enforcement procedures that expired in 2002. Such a category within overall discretionary spending limits could help to highlight important policy goals. By carving out separate limits for certain programs, however, lawmakers could forgo flexibility to make budgetary trade-offs as needs change in the future. Another alternative, which would address concerns about the management of assets rather than their reporting in the budget, might be to attribute a portion of the cost of assets each year (in the form of depreciation) to the programs that use them. Requiring users to pay the costs might improve incentives for agencies to sell assets that are no longer appropriate to their needs.

The paper was written by Jeffrey Holland and David Torregrosa, with contributions from Sheila Campbell, Kathy Gramp, Amber Marcellino, Nathan Musick, and David Newman. Elizabeth Cove wrote the appendix. Robert Dennis, Peter Fontaine, Theresa Gullo, Kim Kowalewski, and Leo Lex directed the research.